Holdout creditors score win in long awaited US Appeals Court "pari passu" rulingArgentina likely to exhaust alternatives before considering compromiseArgentina's performing bond market can suffer further from "friendly", as well as "enemy fire"Cut Argentina debt to marketweight in model portfolio

Hold out creditors litigating against Argentina in US courts have brought forward Halloween holiday this year. The "trick or treat" was issued via a US Appeals Court ruling which resonated negatively in bond markets. The problem for the market is that Argentina is being told to "treat" but performing debt bondholders are the potential victims of a (very nasty) "trick" if Argentina does not concede hand outs.

In this note we complete the thoughts that formed our immediate impressions in response the news of the adverse ruling for Argentina ("Argentina: Court rules pari passu—quick & dirty and negative"). In a nutshell, as we think about the details and possible scenarios our concerns over the risk this litigation poses to Argentine performing bond holders remains large.

This ruling is the key headline risk event that the market has been waiting for but the result is not what the market was expecting. Thus, it is negative for the soverign debt. Whether the risks are worth more than the $7.0-9.5 price gap in long-duration performing bonds that already transpired is the key question investors face.

We believe the market worries are unlikely to resolved for better or for worse in the near term and hence market anxiety may escalate. Given the legal complexities of the case and the fact that a politically-charged decision now lies unpredicatbly in Argentina's lap, we prefer to stay sidelined at this stage and recommend cutting Argentina exposure to marketweight (see last section below).

The ruling is very harsh, raising risks of an adverse "end game" for performing debt

With regards to the ruling there are many things to highlight. We abstract from an analyzing arguments driving the decision in depth (sufficient is to say that the Appeals Court literally trashed a laundry list of Argentina's arguments—with one caveat). The main take aways are the following:

1. The ruling AFFIRMS the judgements of the district court against based on breach of "pari passu" (i.e. issuing an opinion on the "broad" definition that serves establish precedents for sovereigns in general, not just the "narrow" definition based on argument of the "lock law" specific to Argentina).

For practical purposes, this boils down to disallowing Argentina to pay holders of restructured bonds in US territory unless it pays holdout creditors in the lawsuit (with claims worth $1.33 bn)—despite the payments are in a bondholder trust which technically means they are no longer property of Argentina. Specifically, this involves 2005 and 2010 Exchange Securities which we interpret to mean Discount, Pars, GDP Coupons and Global 17s under foreign law, which includes USD-denominated NY law and EUR denominated UK law securities; in contrast, bonds from those same exchanges but under Argentine law, irrespective of whether they are USD or ARS, are not affected as they are paid outside US jurisdiction).

2. The case is REMANDED to District Court so that two issues are clarified :(i.e. the "pro rata" formula and the injunction's application to third parties and intermediary banks) and then will be returned to Appeals court for FURTHER CONSIDERATION.

While this may generate a perception that the Appeals Court can change its mind if the District Court clarifications do not satisfy it, we doubt this is likely to happen. The pro-rata formula (while critical for all parties and potentially controversial) once defined is a technicality and it is unlikely to be scrutinized by the Appeals Court. We suspect that the clarification regarding financial intermediaries can be resolved if a definition is narrowed in a way that institutions are unaffected when they (a) are in the chain of payment for Exchange Securities that do not directly recieve proceeds from Argentina or in trust for bondholders (but caught somewhere between) or (b) involved in transactions unrelated to Exchange Securities being targeted (for example, a payment of a different bond)

3. The ruling does not mention the stays on the injunctions that the District Court concended to Argentina for the purpose of allowing it to proceed with its appeal.

The lack of reference to the 'stays' raises a valid concern that if a solution is not adopted quickly by parties involved, the District Court injunctions and the Appeals Court affirmation would already apply to upcoming coupons on Exchange Securities due in December of 2012 (Discounts and GDP warrants). The worry is that without stays a potentially defensive and hasty political response from Argentina might surface, irrespective of the collateral damage to the bond markets it may entail. However, we believe that—with the remend requested and with Argentina sure to seek a "certioari" of the US Supreme Court—it is more likely that the threatening remedies will not be enforced until the judiciary process is complete (which, given court timing, inclines us to think that December 2012 coupons will be paid as usual). In fact, Argentina's Secretary of Finance Cosentino addressed this issue in a public statement, ratifying that the "stays" are in place currently.

Next steps: The ball is Argentina's (better said, Cristina's) court

The end game in this litigation will depend on Argentina's response. Below are some thoughts on the path ahead and a lot of concerns over the political capacity of the government to find a solution that limits collateral damage to the bond market:

1. Argentina can choose abide by the Courts and settle with hold out creditors the claims. Litigation claims ($1.33 billion) can be settled without affecting Argentina's broader payment capacity (and hence the risk premium on Argentina performing bonds). Argentina can dip into its $45 billion of reserves to make the payment as it currently does for performing debt service.

However, there are economic and a political factors at play that make this unlikely: On the economic side, we note that there are a total of $6.6 billion untendered debt (litigating and non-litigating), mostly foreign law, that could "piggy back" on this ruling to demand similar compensation. And considering that Argentina's definition of claims is limited to principal (but plaintiffs could demand PDI since 2001) the liability can conceivably inflate to an figure in the neighborhood of $11-12 billion. So it is not clear that a "small" $1.3 billion payment (or some lower amount settled privately between plaintiffs and Argentina) closes the door on the issue.

Political considerations are more worrisome. In our view the alternative of settling claims with litigating investors looks like a difficult pill to swallow politically for a government that has publicly blasted the "vulture funds" as public enemy No. 1 (but not exclusively so) of the Argentine people. We give a slim chance to this unless plaintiffs accept a similar deal similar to the restructuring exchange (which allows the government an elegant exit: selling the deal publicly as one that respects the terms of its own original proposal). Yet, should plaintiffs be expected to accept such a proposal after years of litigation? We are doubtful... but we (and bond markets) would be relieved to be proven wrong.

What could trigger an surprise compromise by Argentina? Maybe, the silver lining in the YPF nationalization is that now the government has a need for the state-run oil company to raise funds that help it fulfill the investment goals the President cares about. And maybe, the government acknowledges that it must resolve litigation uncertainty in a cooperative manner to make yields attractive for YPF and make its strategy to solve the energy imbalance feasible again. But too many "maybes"—and a leap of faith that the government will readily adopt economic cost-benefit analysis over political calculation—are involved in this vision for comfort.

2. Argentina is sure to appeal (or seek "certiaori"): Argentina's public statements (from Secretary of Finance Cosentino) in response to emphasized that the latter "is not the end of litigation" making it clear that the next step is to seek a judiciary review of the ruling. What is not clear is if Argentina will appeal immediately or wait for Judge Griesa to resolve on the clarifications required by the Appeals Court.

We understand that an Appeal can be made by Argentina to an expanded Appeals Court before the sovereign would need to seek a "certiaori" from the US Supreme Court. This again suggests that performing bond coupons are not immediately threatened. The clock on the threat to coupon payments on restructured debt starts ticking once the Supreme Court rejects the case or if it accepts it and subsequently affirms the injunctions. The Supreme Court might take 3-6 months to decide to take Argentina's appeal or reject it. So an appeal buys time and reduces the risk of a defensive and hasty response by Argentina that inflicts collateral damage.

A Supreme Court ruling could eventually overturn the Appeals Court. At the end of day, Argentina has already proven capable of doing so in other litigation also involving holdout creditors. Moreover, recall the US government did submit an Amicus Brief siding with Argentina on the (broad) interpretation of "pari passu" that might be taken into account (although the Appeals Court evidently brushed its relevance aside). Assessing those chances, however, is the subject of a different conversation that involves analyzing in detail the arguments supporting the ruling.

3. Argentina can try to re-route the payments on restructured debt: To avoid making payments in US jurisdiction Argentina might consider offering performing debt holders payment of coupons into a new offshore trust.

Legally, this is complicated to the extent that one of the orders of the judge requires Argentina not to modify its payment mechanisms for Exchange Securities. Evidently Argentina, in exercise of sovereignty, may attempt to do so anyway. Yet financial institions under NY law that facilitate such a scheme might be liable to being labeled in contempt of court and therefore Argentina would rely on other institutions to help it carry out such a plan.

But in addition, a successful execution would require solving some operational unknowns. We have heard opinions from legal experts that payment to the Trust in NY is "hard-wired" into bond contracts. If so, to re-route payments offshore (outside US) Argentina may need to carry out an exchange with current restructured debt holders. Yet an offshore payment would sacrifice US legislation and—while it is clear investors have an incentive to facilitate the payment of their coupons—it is not clear if they would rush to embrace a different legislation. Argentina can argue that a full payment in USD in Argentina should be viewed as superior to risk of payments being pro-rata in NY. But following all the noise around risk of "pesofication" we doubt all investors dependant on the BoNY trust structure have the appetite to make the gamble. A foreign non-US jurisdiction (UK?) might offer a (temporary?) shelter to continue payments but 100% participation in a swap of this kind has slim chances.

4. Argentina can unilaterally decide to set aside future coupon payments in an (offshore) trust as a display of willingness and capacity to pay, risking accusations of default. If Argentina does not want to play the cards it has been dealt within the established rules it may consider rewriting these rules in a convenient way. It might be deemed a political "face saver" to announce that it will deposit funds for Exchange Securities in a separate offshore trust that respects restructured bond holders claims but defies litigating creditors claims and US court orders to pay them pro-rata.

This option would lead to further collateral damage in bond markets. If the coupons do not reach their original destiny and the latter is truely "hard-wired" into bond contracts (as has been suggested to us) this option would likely qualify as a default. Of course, technically a formal default triggering CDS would have to be defined by market participants responsible for that process. Argentina's situation, if it chooses to stay current on restructured bonds but paying into a different trust, would at a minimum raise controversial opinions in this process. Moreover, for a CDS trade to look attractive bonds must trade at distressed prices that make them cheap to deliver and it is not clear they will if Argentina actually continues to pay the corresponding cashflows on the bonds.

Final thoughts: Any safe havens?

Unfortunately, Argentina's poor communication with markets does not provide assurance that the sovereign will (or even can) signal its strategy clearly and in a pre-emptive fashion that might help to reduce market anxiety rapidly. Thus, "pari passu" litigation will remain an overhang for the bond market.

All bonds—irrespective of currency—that are under local law and paid through mechanisms not within the jurisdiction of the NY court are spared from the "pari passu" litigation consequences. In the near term, the local law USD bonds like Bodens and Bonars have suffered though less than foreign law bonds due to shorter duration and due to investor understanding that they can continue to be paid by Argentina without third party interference.

We moved overweight Argentina in our EMBIG Model Portfolio on 17th September as a supportive environment post the Fed’s announcement of QE3 provided support for high spread Emerging Maket sovereign performance and we saw a cyclical lift to the domestic economy in 2013, with ‘no news’ for a period in Argentina being good news for bond prices. Today’s 'news' from the pari passu court ruling is a negative risk we highlighted at the time and we see a period of uncertainty ahead. We entered the overweight when Argentina (global) 8.75% $ 2017s were at a price of 100.00, which was a spread to treasuries of 801bp versus the EMBIG spread then at 282bp. We take losses on this overweight and move back to marketweight given the downside risks, with current prices of Argentina (global) 8.75% $ 2017s down at 91.00/95.00 (spread to USTs of 1,053bp / 935bp as at 1.30pm US time 26th Oct).

We rebalance other positions in our EMBIG Model Portfolio to keep the overall portfolio position unchanged. Many questions remain about the next steps in this process, which is unusual in that there is potential risk to bond holder payments that is not being driven by the unwillingness or inability of the issuing government (Argentina) directly. The reaction of the government to this ruling and the next legal stages are not yet known and may turn out to delay or avoid any impacts on bond payments. This keeps from wanting to move underweight at this stage, until we have more clarity on these next steps and given the price drop already. However, we think that any bounces in bond prices will likely be sold into as investors are left with a great deal of uncertainty on the future payment process and where CDS are likely to be a price point that widens as technical triggers are focused on.